UNFAIR VALUE

I’m casually flipping through the pages of Fortune magazine. Right before my eyes is a very interesting company. It is ranked the seventh-largest company in the United States in the Fortune 500 index. It is the most admired company in its sector, number one for "innovativeness" and number 2 for "quality of management”.

The magazine features an interview in which an executive of the company is talking about the great revolution in the 21st century, “as big as internet”. It’s the idea of hedging your risk. He is talking about revolutionary hedging products that give you a safety net against the risks inherent in the business. Say you buy crude and process it. By the time you are ready to sell the output, the prices crash. What would you do? You are not here to predict the prices. You are in the business of refining the oil. So you sell contracts for future delivery of your output. The same basic idea, he says, is now being applied to things you couldn’t have imagined. They have derivative products in weather, fiber optic bandwidth, retail gas, power and water systems.

Suppose your company makes central heating products. In a particular year, suppose we have unusually warm winter. You have a huge inventory of central heating systems for which there are no buyers. You incur significant losses. One more year like this and you are bankrupt. What do you do now? You can buy a call option on temperature of the next winter(!). If the winter temperatures are above mean, you make money on your call option. If they are low, the money you would make selling the central heating systems will be more than the small price you pay for the call option.

I'm amazed! Derivatives on temperature? Wow. Do you believe in global warming? Go for a 100- year call option. When the molten ice from glaciers inundates the low lying great cities of the world, your account will be inundated with money.

December 2001

My copy of that Fortune is still fresh. Enron Corporation, the most admired company in the energy sector, has filed for bankruptcy. I’ve decided against opening a derivative trading account with my broker. I’m fine with the risks that I can measure. No, thank you.

February 2002

Warren Buffett, in his letter to shareholders[1] writes, “Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”

In two half pages, Buffett describes the main problems with derivatives, namely – counter party risk, problems in accounting for derivatives (what he calls as Mark-to-Myth accounting), the tendency of derivatives to exacerbate troubles in an already troubled corporation, the daisy-chain link effect where problems of one counterparty can create a chain reaction which can threaten the stability of the entire financial system and finally, the fact that derivatives curtail the ability of regulators to curb leverage.

He predicts the doom in no uncertain words:“The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear… The derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

May 2002Charlie Munger, adds a timeline to the doomsday prediction[2].“I'll be amazed if we don't have some kind of significant [derivatives-related] blowup in the next five to ten years."

Year 2008- 2009

The doomsday arrives. Derivatives deal a deadly blow to the economic system. Once mighty companies, which had seen two world wars and dozens of boom and bust cycles, are left either dead or half dead. Bear Sterns, Lehman Brothers, Merrill Lynch, AIG, WaMu, Wachovia, City…the list keeps getting longer.

WMDs hit IndiaBack home the news isn’t good either. In September 2008, 165 Indian companies make a provision of Rs 9,815 crore for mark-to-market (MTM) losses on forex loans, receivables or derivatives. Mark to market loss means that the value of the derivative instrument in the market is less than what the company was showing in the books. In the next quarter, a total of 335 firms made MTM provisions of Rs 9,618 crore[3]. To put the loss in perspective, the aggregate profits reported by 2,478 Indian companies, in the same quarter, was 47,706 crore. Imagine losing a fifth of profits to gambling.

In a scenario of falling profits, the forex and derivative losses may soon drag the companies into red. The most unfortunate part is that the list of companies which have reported such losses includes companies which are known for excellence in their businesses. These are not the companies from the financial sector that couldn’t have avoided these losses. These losses are a result of their well thought-out decision to hedge the business risk. If you see the notes to the account, most of these companies will claim: “The Company does not hold or issue derivative financial instruments for trading or speculative purposes”.

Here is a snapshot of the forex losses reported by prominent Indian companies in in the quarter ending December 2008

Company

Loss

Company

Loss

Ranbaxy

1091

Maruti

61

Essar Oil

679

Dr Reddy’s

49.3

TCS

251

Cipla

42.6

M&M

182

Suzlon

34.9

JSW Steel

177

Tata Metaliks

34

GHCL

101

NIIT

32.8

Tata Motors

226

Gokaldas

20

# All figures in crores, Source: Business Standard

Why are we seeing these losses? It’s important for investors to understand the risk being taken by the companies in an effort to minimize volatility of earnings. The events from all around the world have put a big question mark on the utility of hedging.

Let’s understand why these companies entered into these contracts in the first place. Suppose a company produces garments and exports them to the US. The company sources most of its raw materials fromthe domestic maket, so the cost incurred is in rupees. The proceeds of the sales are denominated in dollars. Suppose it takes 3 months to receive the payments on the goods sold. If the dollar depreciates between the moment the costs are incurred and the moment when the customer pays, the company will get less money than it would have got if the goods were sold and paid for immediately after they are produced. The fluctuation in the value of the dollar will cause their profits to go down when the dollar depreciates. The company doesn’t want to shock the analysts who give so much emphasis to quarter on quarter growth. So it enters into derivative transactions that enable it to profit from a depreciating dollar.

Now consider this.

The company is in the business of garment manufacturing and it has no expertise to predict the direction of the movement of the exchange rate. If it had, it would be better off shutting the garment business and start making money in betting on exchange rates.

Dollar to rupee exchange rates have shown no clear trend. In the last 10 years, the dollar has been moving in the range of 40 to 50 rupees.

Had the company focused only on its garment business in the last 10 years, ignoring the movement of the exchange rates, its profits would have been lumpy but the aggregate profits would have been higher because there would have been no cost associated with maintaining a treasury operation to bet on the dollar and to pay brokerages on the derivative instruments.

The only instance where the hedging will help is when a company is working at a very low margin, say 10%. If it knew that the dollar will depreciate by 10%, it will not produce and export garments to the US because it is a loss making proposition. For this company, it is critical to lock the exchange rate at the current rate and hence it makes sense to hedge the currency risk. But why should companies in software or pharmaceuticals, which operate on 30%+ margins, indulge in hedging? They will still be exporting even when the dollar depreciates by 10% or so.

I’m not saying that the concept of hedging itself is bad. But the way the corporations are indulging in speculation in the garb of hedging, I have no hesitation in terming the whole concept as evil and in making a case for an outright ban on hedging. Who says morphine doesn’t have medicinal properties, which when used appropriately can help relieve the pain? But talk about these beneficial properties to drug addicts, they will award you noble prize!

(I’m not joking. Myron Scholes and Robert C. Merton received 1997 Nobel Memorial Prize in Economic Sciences for their work on derivatives and options. They were members of the board of the hedge fund LTCM, where they used their exotic mathematical models to create complex derivative structures which led to the collapse of LTCM in 2000, after losing $4.6 billion in less than four months following the Russian financial crisis. The Black-Scholes model, created by Fischer Black and Myron Scholes, is still widely used in valuing the options.)

Another big reason for the forex losses reported by Indian companies is the external commercial borrowings (ECBs). The interest rates in many countries are low compared to those in India. That doesn’t mean a great opportunity. In a talk, Warren Buffett said that Berkshire can easily raise a 10-year loan at 1% in Japan but he will have to invest the money in something that is yen denominated, because he doesn’t want to get exposed to currency risk. Imagine the investor, who has an enviable record of 21% per annum returns for the last 45 years, refusing to take a 10-year loan at 1% due to currency risk and then look at these idiots from corporate India who went all around the globe with the begging bowls for loans at 6% to 10% that were many many times their networth.

What the hell were they thinking? Well, they had hedged their currency risk. If a company has a revenue of one billion dollars from exports and it takes a billion dollar loan, it may think that it is not exposed to any currency risk. If the dollar rises, its revenues will rise and that will offset the rising value of the loan in rupee terms. Any guesses on what can go wrong?

What if revenues fall from one billion to 500 million and the dollar rises by 10%?

What about the accumulated interest if the bond holders choose not to convert their bonds into equities?

What about refinancing of these loans?

Corporate India wasn’t thinking about all this. They ventured into even more adventurous pursuits. Suppose a company’s revenues are denominated in pounds and it finds a golden opportunity to raise a loan at cheap rates in dollars. The company goes for the loan and enters into dollar-pound swaps to hedge the risk. Now you have 3 currencies. It doesn’t stop here. The companies which export to all over the world have derivatives denominated in many currencies. When things go wrong, these companies have no expertise in dealing with the complexities of derivatives.

And things did go wrong. The derivative losses have become regular and ugly surprises in the financial results in India. I’ve reason to believe that India will be better off banning the ECBs and developing a more liquid corporate bond market within the country. You cannot allow teenagers to carry guns because if they do, they will shoot themselves in the foot and sometimes right in the middle of the eyes.

Charlie Munger, Vice Chairman of Berkshire Hathaway, minces no words in criticizing the derivative. To rid Wall Street of its Las Vegas tone, Munger suggests leveling the options exchanges in Chicago and New York, and banning completely all derivatives contracts. It’s not rhetoric. He knows what he is talking about.

Parasites that they are, the financial institutions of the world had promoted reckless gambling in the name of risk management and they are suffering the consequences. But all the corporations and their investors must understand this:

The risk you are exposed to, does not get reduced if you take counter measures that are dangerous and beyond your expertise. If you are going alone in a jungle full of wild animals, you should NEVER carry a gun if don’t know how to use it, when to use it, when not to use it and finally how to use it well enough to kill in one shot.

If you ignore the risks you have hedged, you will soon be wedged. Hedging always involves balancing of two opposite external forces and this is always a daunting task. The more complicated your hedging structure is, the more risk you are taking of collapse of the entire structure.One example is a case where a single factor causes simultaneous strengthening of one force and weakening of the other. This will cause the balance to be distorted. For instance, if you think your dollar revenues are a hedge against the risk due to dollar denominated loans, you are wrong. A single factor, like the weakening of US economy, will cause fall in revenues and at the same time, the falling exports will put the rupee under pressure blowing away your hedge.

Beware of what Charlie Munger calls, a lollapalooza effect, created by the confluence of multiple factors working together. If the business was faced against a single risk, it is easy to hedge against it but when multiple factors start contributing to the risk, you may be better off without the false sense of security.As Charlie says: Somebody has to step in and say, "We're not going to do it –it's just too hard."It doesn’t take anything more than common sense to close down your umbrella when the rain is accompanied by storm. You are going to get wet anyway, so why risk losing the umbrella or yourself with the umbrella. But the events prove time and again that common sense is not so commonly observed in corporate echelons.

Hedging has both a moral and financial cost associated with it. Every time you hedge against a risk that was just in your imagination, you lose money. Every time you pay money to your financial advisors to help you reduce your risk and to buy the derivatives, you are incurring a cost which can, in the longer run, add up to more damage than the unhedged risks may have caused together. Buying insurance in Black Jack is a losing bet precisely because the house structures the odds in such a way that you always lose money in the long run.But the financial cost is nowhere as big as the moral cost. When you start hedging, you will create a unit in your finance department to handle the derivative contracts. You will not hire a layman but go on to hire a bright guy with an MBA in finance who boasts 10 years of experience at a great financial institution called Lehman. There will be times when the profits from derivatives will be more than the profits from your business. That will be the start of the transformation of your company into a casino.Because you think you have safeguarded against your risks, you will go on to take more and your bright treasury department will enter into more derivative contracts to hedge those risks. May be they will hire more people. It won’t be long before the company will implode.

Investors in India are in for even more ugly surprises. The new accounting standard AS-30 is optional till March 31, 2011. While most of the large companies have already started using it, I’ve no idea how many small companies are still avoiding it. The problems inherent in accounting the value of illiquid derivatives will ensure that even when the standards are enforced, there will be ample scope for creative accounting.

Munger says, “To say accounting for derivatives in America is a sewer, is an insult to sewage".